Understanding the Impacts of the Tax Cuts and Jobs Act on Real Estate and Construction
Real Estate and Construction
Starting off, we’ll walk through what we’re going to accomplish today. We’ll start off with some of the general provisions, and the state tax impact. A lot of these general provisions are what you hear about in the news, and in the newspapers.
We’ll move into interest expenses that have a huge impact on the real estate and construction industry. We’ll talk about some depreciation rules, and also make sure we talk about the things that you can do to take advantage of rules that did not change.
There’s some new loss limitations that everybody needs to be aware of, because they will definitely impact the 2018 tax returns going forward, as it relates especially to individuals. We’ll talk about the carried interest provisions. They are not earth-shattering, but they are significant. It is going to impact how a lot of you run your business, and turn over your properties.
We’ll end the day with the section 199A deduction, which is a 20% pass-through deduction allowed on a qualifying business income against your individual taxes. The most important thing that this act did is it reduced the overall tax rate. The highest rate was 39.6%, it’s now dropped to 37%. In addition to lowering the rate, they also ramped up when each bracket will take effect.
We still have the same number of brackets. There are still seven separate tax brackets that you have to go through, but as I said, the highest is now 37%. Most of the low brackets saw very little change. The new bracket is 22%. That’s part of what the media has jumped on, and it is not helping out the lower middle class citizens with tax benefits.
We’ll see in a few minutes that there’s some benefits that they’re going to get that really won’t impact a lot of the higher tax paying individuals. The first big benefit was that the Standard Deduction was doubled. It went from $12,000 to $24,000. This is huge for the lower income brackets because for most of them, if they itemized they barely reached the threshold.
They may have had a few thousand dollars of real estate taxes, they may have had $5,000 of state taxes, and then you add in some charitable contributions that got them over the $12,000 threshold. Well now they don’t have to worry about that, and they automatically start with $24,000 of Standard Deduction. The Act did remove the exemption for dependents and taxpayers, which was about $4,000 per taxpayer independent.
Now for higher tax paying individuals, this was phased out, so they got little benefit of it in most years. But again, it was removed in this tax law. We’ll talk about what they did to replace that. Regarding the home mortgage interest deduction after December 15, 2017, for acquisition debt you’re limited to $750,000 to calculate your interest expense deduction on your itemized deductions.
This is only for a new debt after that period, and they did grandfather in the old rules of $1 million of acquisition indebtedness with the passing of the provision. The other big change is that home equity lines of credit are no longer deductible. In the past, you could deduct interest on up to $100,000 of home equity debt. While it was removed, they did still allow it to be considered if the debt was used to significantly improve your residence.
As long as you didn’t go out and do a debt consolidation or paid it to private school tuition, then you’re still going to be able to deduct that interest. The state and local tax deduction has been a huge controversy. It was one of the provisions that almost prevented the passing of the bill, because high tax paying states, such as California, Pennsylvania, New York, were extremely opposed to this rule.
You could now only deduct up to $10,000 of state and/or local taxes. That includes income taxes, real estate taxes, and ad valorem taxes. Another aspect of this provision that you may have seen on the news is property taxes. Many higher paying states had citizens running to the Real Estate Appraisers office to pay future property taxes. The thought being, if you pay them before December 31st, you got a deduction on your 2017 tax return.
One of the first clarifications the IRS made was they that you can only deduct in 2017 taxes that had been assessed before December 31st. What that means is, for instance, Fulton County, because they were so late in getting out their tax bills this year. They had a January due date for some of their tax payments, for property taxes. Now you are allowed to pay those before year end and still take the deduction on the 2017 tax return.
What you couldn’t do is say, “My taxes for 2017 were $10,000, so I’m going to go ahead and make a $30,000 payment to the state government, and take the full deduction in 2017.” A very important difference to note there.
Another big change is that 2% deductions miscellaneous itemized deductions are no longer allowed. These are your tax preparation fees and your investment fees. If you’re an employee, these are unreimbursed business expenses. It’s important to know that those are no longer allowed moving forward. All of these deductions were limited, or removed in an effort to make more people qualify for the $24,000 Standard Deduction.
You’ve probably heard a lot of people say that they don’t want people to be able to file taxes on a note card, or a post card. I don’t think we’re going to get there anytime soon, but it will greatly increase the amount of people that use the Standard Deduction, as opposed to the itemized.
One of the beneficial provisions in the law is on the ability to deduct charitable contributions, the limitation is increased from 50% of adjusted gross income up to 60%. This doesn’t help if you’re going to use the standard deduction.
However, it can be a great way to increase your itemized deductions, and take advantage of more charitable giving. They did, however, move the benefit you got for making payments to a college, or a Secondary School Athletic Association in exchange for priority seating, and athletic events.
That’s probably big for a lot of you, because you make donations to various universities; Georgia, Georgia Tech, Kennesaw, Georgia state. In order to get the football season tickets, a lot of you use those tickets for entertainment purposes. Well, they’ve essentially made all of that non-deductible, and we’ll talk about the entertainment piece in a minute.
Another provision revolved around alimony and divorces. They removed the ability for the payer to deduct alimony payments, and also the recipient no longer has to take those payments up as income, beginning with divorces executed after December 31st, 2018. The important aspect of this provision is that it encourages you, if you’re thinking of a divorce, to finalize it this year as opposed to next year.
The payer has to pay tax on the income before it is given to the recipient. It’s going to limit the amount that the payer can give. In the past, generally the person paying alimony was in a much higher tax bracket than the person receiving alimony. There was a gap that allowed the recipient to have a much higher after-tax return than the payer. That has gone away.
While they increased the standard deduction, they removed the personal exemptions. The hardest part with this is, what do you do with families that have multiple children? Especially families that have more than two children. Their benefit would be very minimal with the new Standard Deduction.
They increased the child tax credit, which gives you a $2,000 credit for each qualifying child, which is generally a child who lives with you, has a social security number and is under the age of 18. It’s now refundable up to $1,400, so even if you pay no tax, just by having children you can get up to $1,400 in refunds. In the old law, these credits were phased out very quickly. I believe in the low $100,000 range you are phased out almost immediately.
They’ve doubled those amounts. Now, single and head of household taxpayers are phased out beginning at $200,000 and fully phased out at $240,000. Married filing joint tax payers are eligible to take the credit up to $400,000 of taxable income, and they’re fully phased out after $440,000. So the child tax credit will be much more important moving forward, to help offset the loss of personal exemptions.
For businesses, they enacted a new credit that will be available in 2018 and 2019. These are the only two years it’s available unless it’s extended by congressional act. That allows businesses who pay employees while out on family medical leave to get a credit for a portion of those wages. That credit is 12.5% as long as you pay your employee 50% of their normal salary.
As you go from 50% up to a 100%, that credit can increase up to a maximum of 25%. What this means is, if you’re a business owner and you have employees that go out of medical leave, for the first 12 weeks that they are out on the Family Medical Leave, if you pay them a 100% of their normal salary the government will subsidize 25% of that.
The important thing to note here, while it may be beneficial to change your current policy, you want to be careful because this credit does expire at the end of 2019. While your employees will love an enhanced policy of payment while they’re out, they are not going to like if you reduce it, once the credit expires.
I would at least recommend looking at your policy, and seeing how much you’re paying today, and whether it may be beneficial to at least get up to the 50% bracket or 50% of normal salary.
Alternative minimum tax. For corporate tax payers, they eliminated it completely and most corporate tax payers weren’t paying it anyway. It wasn’t as prevalent as it is in the individual tax tab. Congress couldn’t eliminate it entirely for individuals, because they still needed to have some people paying it in order to help with the reconciliation of the bill for budget purposes.
They increased the AMT exemption up to almost $110,000 for individuals, meaning you calculate your AMT taxable income and you get $110,000 deduction off the top before you calculate the tax. Then they also increased the phase-out of AMT to $1,000,000 for married taxpayers. This is a substantial increase from the current rate, which is in the $200,000 to $300,000 range.
Because they’ve eliminated itemized deductions so much, most taxpayers who are accustomed to paying AMT are no longer going to be paying AMT tax. There’ll be very few clients and taxpayers who are paying this tax.
The estate and gift tax has doubled the exemption for the exclusion of lifetime gifts. They’ve taken it from $10 million currently up to $22.4 million if you’re a married couple, or $11.2 million dollars. I’m sorry, it went from $5 million to $11.2 million and from $10 million to $20.4 million. Individuals can exclude the first $11.2 million of property from their estate, and married couples can exclude the first $22.4 million. This does get indexed for inflation through 2025. After 2025, the exemption comes back and it goes back to the $5 million per taxpayer. It has again been indexed for inflation.
Another important thing to know about this is that it’s important to go do your planning now, and not wait. The Estate tax has always been a hot button issue in Congress. Anytime reform comes up, you have one side that wants to eliminate it, and one side who insist that it’s necessary to raise money for the government. At the end of the day, it really doesn’t raise that much money.
Most of your wealthiest taxpayers have already done their estate planning, and they’ve maximized their deduction and exclusion. Now they’ll do a little bit more to make it more advanced this exclusion. The estate and gift tax has never been a huge moneymaker for the federal government.
Meals and entertainment. Normally meals and entertainment fell into one category, and they were 50% deductible. The reason for that is, because the IRS always presumed there is some sort of personal benefit to the expense, they unlimited 50%. Well now, meals are still 50% deductible, but entertainment expenses are no longer deductible at all. We talked about sporting events earlier.
No longer will taking employees or clients to Hawks games, or Falcons games be deductible expenses. Now there’s another caveat to this, as far as it relates to taking non employees out for dinner, or lunch and whether or not that’s deductible. Generally if you just go to lunch, that’s all you do, and we feel it is going to be 50% deductible.
There is some thought that if you take a vendor to a dinner, and then after dinner you go to the Hawks game, that the Hawks is definitely nondeductible. The question has come up, is the entire night’s expenses tainted by that entertainment aspect? Quite honestly there’s been no definitive guidance on that, and we’re going to have to get more from Treasury Department to understand that.
Maybe there’ll be some clarifications from Congress that make it easier to understand. Just know that there is a potential that there’s some tainted expenses out there if they have a component of entertainment to them.
Another difference is, if you’re providing employees lunch or dinner on your premises, under the old law you could deduct 100% of those cost. The new rule says all of those are 50% deductible, and after 2025 they are no longer deductible.
If a partnership has a more than 50% change in ownership during a 12-month period, and that’s a change meaning sold or exchanged, it does not include transfers within family, then under old law you had to file two tax returns. One, pre transfer and one post transfer, and they were called technical termination. They were technical terminations because the IRS considered the partnership terminated, but everything still went on the same. You had the same tax ID numbers and the same name of the partnership. It did allow you to make some new elections.
You could elect to be a cash basis taxpayer as opposed to accrual. You could change your depreciation methods on certain items, and so there was a way to get some benefits that maybe were lost because of prior tax changes. That rule has gone away, so you no longer have to file short year tax returns for technical terminations.
It’s just one tax return and you just report the transfer. You still calculate the income as if the books were closed on the date of the transfer, and it’s allocated accordingly, based on the ownership. They expanded the ability of taxpayers to use the cash method of accounting. It is now up to $25 million gross receipts test, when in the past it was $10 million.
Now, for most real estate, that was an issue. You generally would like to be an accrual taxpayer, because you wanted to make accruals for expenses and other items before year-end and deduct them on your return.
For construction companies, this is big because depending upon where you fall in having payables versus receivables, it may be more beneficial to move to a cash basis. Now a caveat to that is, while the decision to use cash or accrual is at the entity level, $25 million test is on an aggregate level, or if you have five or fewer people who own 80% or more of multiple entities.
Those entities all get combined, so you’re looking at real estate funds that are most likely going to be combined. In addition, you’re looking at the closely held real estate holdings of a few people. Maybe you’ve got a three person core of investors that own most of your real estate, then those entities are most likely going to be combined for testing this $25 million gross receipts.
Now for construction contractors, if you’re eligible to move to the cash basis, you could also move to the completed contract method. If you’re expected to complete construction within two years of starting, and you meet the $25 million gross receipts test, that’s beneficial because no longer do you have to calculate percentage of completion for smaller type contracts.
Both of these changes are allowed as automatic changes for the IRS, so if it’s determined that’s beneficial for you to do, you file a change in accounting method with the service. They will automatically accept it, which basically means there’s no $12,000 user fee to get an opinion. You make the adjustment, and the adjustment is passed through in the year of change 100%. Especially if it’s going to result in a decrease in tax, or in taxable income, it’s beneficial to make this change.
Like-kind Exchanges. They kept like-kind exchanges in the law, but it now only applies to real property not held for sale. That means if your investment property is not your home construction property, a home builder cannot use like-kind exchanges for their homes, but a real estate investor can. It is not tainted by the fact that real property has an inherent personal property component.
We all know, especially with apartments that you have appliances, cabinets, fixtures, all of that in, you’re still going to qualify, because the basic component of your property is real property. As a result of all of these changes, you have states that have no idea what they’re doing. They’re going to have to make a lot of decisions in the next couple of months.
I know Georgia’s General Assembly is meeting right now, and they’re having to debate this and decide what they want to do. Most states have historically complied with portions of the code, or said we’re going to adopt the tax code as of this date, with the exception of these provisions. Honestly if they do nothing, most likely they’re going to see a huge uptick in tax revenue, because of these changes.
The law state tax deduction alone would cause an increase in state revenues. It’s most likely they’re going to try to have some add back for those state taxes, or even allow miscellaneous itemized deductions. They’re probably not going to accept some of the more taxpayer friendly rules, such as the 20% business deduction or some bonus depreciation, which a lot of states currently don’t accept.
The other impact that you could have is, you need to pay attention to how you use the $10,000 cap on income taxes, because especially if you have out-of-state taxes that you pay, the state may not allow a deduction for those taxes. They may give you a credit, they may not. So you want to use your real estate taxes first, and then your state taxes. Based on these changes, if they did nothing, there’s going to be about a 33% increase in their revenue base.
Some states have tried to get around the $10,000 deduction cap, like instituting new credits that are charitable contributions. By giving you a state credit they would not count as state tax payments. They would count as charitable deductions for itemized deduction purposes. In Georgia, the most well-known of these is the Georgia gold scholarship credit.
There’s also a rural hospital credit and there’s a public tuition credit that just came into law this year. Now most of those credits are capped at the individual level, while the gold credit is normally capped at $10,000 if you have a business that has Georgia income.
That cap is usually reduced further, and limited to between 50% and 60% of that $10,000 when it’s allocated out. Another thing to consider is, Georgia does not allow you to itemize your deductions unless you itemize for federal purposes.
Now the Georgia standard deduction is only $3,000. That’s extremely low relative to the federal deduction. It may be beneficial on an overall tax return basis to itemize federal deductions, even though they’re lower than itemized state deductions, because you get a bigger benefit. This is something you’re going to have to do on a return by return basis, and it’s not a blanket slam-dunk.
Ross Boardman: Everybody, happy Friday. As Dan said, my name is Ross Boardman and I specialize in multifamily housing and strip centers. I’ll be taking you through interest expense and depreciation changes in the new tax law.
Regarding interest expense, I like to call this the 25-3 rule. It really doesn’t come into play unless you’re grossing $25 million on average across three years. Really we’re talking about the real estate funds, like we were earlier with the $25 million limit.
With this, if you’re earning $25 million on average across three years, your interest expense deduction is going to be limited to 30% of your adjusted taxable income. This is a modified taxable income that doesn’t include depreciation until 2022.
We’re working more on an [inaudible 00:31:28] basis here. Business interest income from that taxable year will also be included on top of your 30% deduction. If you’re doing shadow loans or anything like that, then you’re bringing in interest income.
Also in this provision is the 80% common ownership rule. If we’re talking about, like Dan said earlier, a group where you’ve maybe got a GP at 10%, and an investor at 90% across multiple entities, we’re going to have the test for that $25 million gross across all of those entities. The real estate industry got a nice soft ball here, where unlike other industries, a broad spectrum of real estate activities can make an irrevocable election to get out of this 30% limitation here.
As you can see on the screen, there’s a lot of different activities up there covering most real estate and construction activities. However, with that election, you have to concede a little bit and take on a new depreciation system. Rather than the makers depreciation system that you’re used to, where property is 39 or 27.5 years, and qualified improvements are 15 years, we’re going to be looking at a 40, 30, and 20 year depreciable life for your real property.
There’s really not that much difference between the new ADS and the makers system. It could be very beneficial to actually make this election and take the reduced appreciation, but be able to deduct your full amount of interest expense. This is just something that each entity will have to do a little bit of planning on, and consult with their personal advisers about.
One more thing is that you will not be able to take bonus depreciation under the ADS, but we have other tax planning tools in the depreciation section that will make up for that. If you don’t deduct all your interest and you decide to go to the route that we’re being limited, we’re going to apply the tax law. I’m not going to do the irrevocable election, I like the way my depreciation systems run right now.
The way it all play out is that any excess interest that’s not limited will be added back to the partners at a pro-rata basis. That’s going to hit each partner’s basis year by year. Over the years it will keep taking down the basis, until the point of sale, where it’ll be added back to the basis. It won’t be a taxable event, and it won’t affect your year by year really, except for that your basis is going to keep dropping. It’ll all come back together at sale.
We’ve got a nice illustration here that runs 2018 to 2021, and then what you’re going to look like when the depreciation is finally added in 2022. In this example, please note that this would be considered as one entity in an 80% ownership structure, where we’re aggregating all the entities with that 80% ownership. This one entity has $1.5 million of rental income and $625,000 of operating expenses. So when we look at our limitation, we get capped at $260,000, with $2500 of interest.
If we have $300,000, this is where we’re talking about that the $37,500 will not be allowed to be taken as a deduction, but rather it is going to be hitting the partner’s basis year by year. If we fast-forward to 2022, you can see there’s a massive impact when we actually add depreciation into this, because of the reduced taxable income. The limitation is reduced by that much more, by 30% of that reduction.
In similar fact patterns, just by adding in the depreciation, we shot up from $37,500 of disallowed interest deduction to $142,500 in a four year span. Like I said, there’s a lot of planning around this. If you’re at that $25 million threshold, and you’re a highly leveraged company taking on debt across multiple entities, this is definitely a decision you want to make with your advisor. Do a little bit of planning here to see if we need to make elections in certain entities to be able to get out of the $25 million range.
Regarding depreciation, the real estate industry has a minor gift here. It’s nothing crazy, but it should make everyone’s life a little bit easier across the board. We certainly like this, so we’ve got three definitions from the past law that were complicated and just took time to think through. Administratively, its hard to test on our end. Now we’re rolling Qualified Leasehold improvements, Qualified Restaurant improvements, and Qualified Retail improvements into one definition called Qualified Improvement Property.
Qualified improvement property only has two qualifications: it must be made to the interior portion of the building, and it must be placed in service after the building was placed in service. That’s as easy as it gets. As long as it’s not outside, you’re pretty much set to call it a qualified improvement property. Whereas before we were sitting in here, dealing with placed in service after three years of the building greater than 50% square footage for restaurant, and it was just a little more complicated. This simplifies everything up a little bit.
This is generally going to be 15 year period recovery property still, so no worries there. But keep in mind that if you’re making the election in the interest provision, then you will not be able to take the 15 year period. You’re going to have to roll with the 20 year ADS period. That’s just a consideration, but again it is a minor concession to be able to deduct all of your interest expenses in our opinion.
Bonus depreciation has been a nice tool for quite some time now. I’m sure most of you have seen this on your returns, and consulted with us about what kinds of assets are eligible for this. However, under the new tax law we have a nice increase from 50% bonus to 100%. Essentially in asset, that bonus will be able to be written off in that year that you place it in service.
One more nice provision they gave us is that this 100% rule, is actually fairly retroactive in the fact that, it comes back and starts in 2017. The returns that we’re working on you for right now, if you’ve actually placed something in service after September 2017, that’s 15-year properties or FF&E. We’ll be able to place some of this into bonus this year.
You can’t do any mixing and matching, which is unfortunate but understandable, since they gave us the nice provision. Starting in September of 2017, 15 year property will still be at 50%. 15 year property is actually not eligible for bonus depreciation starting in 2018, so you can still take your 50% on 15 through the rest of 2017. In addition to that, you’re able to start using the 100% on your FF&E fixtures and equipment starting in September of 2017 on the tax return.
Something we’ve seen going around is kind of a vanilla tax planning strategy here, and some kind of haphazard advice that Section 179 is about to be your new best friend. We should use this heavily, since Congress gave this as a gift. They bumped it up from $500,000 of 179 expense to a $1 million. This is actually very similar to bonus depreciation. Now we’re talking about a lot of FF&E, a lot of your appliances that you were able to write off in year one.
However with the 179 comes a pretty large pitfall in that there’s a phase-out threshold. If you place over $2.5 million of assets in the service in the year that you’re taking 179 expense, the dollar amount above $2.5 million is going to reduce your 179 expense dollar-for-dollar. If you’re not careful here and you don’t actually truly plan this out and sit down and look at the assets that are being placed on the balance sheet and put in the service, then you could end up reducing your whole 179 expense and not gaining any benefit from this provision.
Don’t just go run out and think that you can 179 everything. But we do have nice provisions that we’ve had for quite some time now called the repair regulations. I think now more than ever, we’re going to be leaning on those repair regulations, since 179 has included now roofing, air-conditioning, and fire protection.
We believe that paving another kind of asset that’s along the lines of those I just mentioned will be included, as well as furnishing lodging, beds, and furniture. There’s not really much of a difference between taking 179 on and taking the full write-off and just running it as a repair.
We’re going to increase our appetite a little bit to lean on the repair regulations even more here, and not run into some depreciation recapture situations later down the line, when we come to sale because we got too heavily into 179 expect. That pretty much covers our interest expense and depreciation. I’m going to pass it back to Dan to round out loss limitations and 199A deduction.
Dan Murphy: One thing I really want to point out before we talk about this with depreciation, is that the tax law did not change related to lower live property, meaning a cost segregation study can’t stress it enough. A cost segregation study still makes a lot of sense, because you can take bonus depreciation on those lower lived assets, while still being subject to the ADS 40-year, 30-year, 20-year rules on that property. It’s still something you want to really make sure you paid attention to.
With the new law we’ll get into some loss provisions. There’s two changes that were made that will have a big impact moving forward. The first is the $500,000 lost limitation on business losses. That’s $500,000 for married filing joint, $250,000 for single taxpayers. In real estate, we are accustomed to taking many deductions today and carrying forward any losses to the future.
When we’re moving forward we want to be careful, because you’re only going to be able to deduct $500,000 of those losses, no matter how much we create with other deductions. This is done at the individual level, it’s $500,000 per taxpayer. It means you don’t want to get too carried away with deductions and creating issues that are going to hurt you down the road.
You’ll be able to use those limited losses, if you’re carrying forward any, against future income. It does say that income includes games from trader business, which would generally include the sales of real estate as trade or business gains. We do need some more clarification from the Treasury Department to make sure that that’s applicable. We want to be able to offset any carry forward losses against those gains in the future.
Just looking at it on a one-year basis, if you had a taxpayer married filing joint with a million and a half of income, maybe some from non-business income, and then $800,000 of business loss. Under the old rules the taxable income would be assuming no other deductions. The taxable income would be $700,000, and they’d have no loss carried forward. Under the new rule, they are limited to $500,000 of loss so they’re still going to pay tax on $1 million of income. That $300,000 spread at the highest rate is $110,000 for federal purposes.
This is a provision also I can see the state’s latching on to, and saying that we’re going to conform to this as well. Now the state is going to get another 6% of that $300,000. You’re going to start to see a substantial increase in tax on a year by year basis, if you’re not able to use all these losses. The next change was to net operating losses, and the old carry back rules, that you could carry them back two years, and care forward 20 years.
Those have gone away beginning with losses created after December 31st, 2017. That does not include this year’s tax returns. On the 2018 tax returns going forward, those losses can be carried forward indefinitely. However, in order to pay for this legislation, both of these loss provisions were put in to extend the period of time the tax payers use losses. They needed to get tax payers to carry losses past 10 years, in order to meet the requirements of budget reconciliation in the Senate.
Another provision they put in with net operating losses is that you’re no longer able to fully utilize 100% of the loss moving forward. You are only going to be able to deduct or utilize the loss against 80% of your taxable income. You’re no longer going to be able to completely eliminate your taxable income with prior losses.
Just looking at a quick example, if you have a tax payer that generates a $90,000 net operating loss on the 2019 return, they have $80,000 of taxable income. They’re going to be able to deduct $64,000 which is 80% of the $80,000, and the remaining $26,000 will be carried forward. Rather than under the old rules, where they would have zero taxable income in 2019, instead they’re still going to have $16,000 of taxable income that they’re going to have to pay tax on. Again we’re extending out the period of utilizing these losses.
Carried interest provisions. With the new legislation, profit interest, promoted interest, and carried interest are now subject to a three-year holding period. The key thing there is that it applies to transactions occurring after December 31st, 2017. It is not just new interest after that period. That’s an important distinction and I’ll tell you why.
I had a taxpayer who was supposed to close on December 23rd, 2017. He had a 30% promoted interest, and held the property for two years. The sale got pushed off and closed, I believe on January 3rd or January 4th, I can’t remember exactly what date. That 30% carried interest is now a short-term capital gain rather than a long-term capital gain.
Another thing about this rule, is there is no proration of that treatment. It is an all or nothing test, so if you hold it two years 364 days, it is all ordinary income. You don’t get to prorate it and say that only the remaining pieces are short-term capital gain. Another aspect of this is that we don’t know how it applies or when the clock starts ticking.
When I say that, what I mean is the law is written to say that it starts when you receive your partnership interest. Usually you know that date, however the example that Congress used to explain the rule was a hedge fund example that says, “A hedge fund sells an asset they held less than three years.” Therefore the hedge fund manager, rather than getting long-term capital gain treatment on that investment, he gets short-term capital gain treatment.
Well the question is, what if that hedge fund has been around for 10 years? He’s held his interest for more than three years, it’s just that asset. There’s some ambiguity as to what assets are going to be subject to three years, and when that three year starts.
One thing people will say, and these are actual questions that we’ve received from clients is, “Well what if I just go out and create 50 LLC’s and give myself a carried interest in all of them today? Then as I do deals down the road, I just pull LLC-1, LLC-2 or whatever I need. Then my whole period starts today, but I don’t actually buy anything until two years from now.” We are pretty confident that that’s not going to pass muster.
For a lot of these provisions, as Congress was negotiating them, they had specific rules that said they didn’t want people to gain the system in a non-substantive way. So don’t go out and start creating LLC’s. Another problem that we run into a lot with real estate is, you have a capital amount that you put in, but then you earn a promote on the back end. We don’t know how that’s going to be treated.
We did put an example though in here that gives you an idea of how it might work. In which case, you’ve got A and B contributing. $90 by A, $10 by B. You go out and buy piece of land for $100. The partnership agreement says upon liquidation, everybody gets their capital back first, and then it’s split 60% to A, 40% to B. We’ve gone from 90-10, the money that went in, to 60-40 after everybody’s gotten the money.
Now we come to year two. We sold the property for $200, so A would get a $150 and B would get $50. Well, we know that these receipts include that promoted interest, but they also includes the capital that they put in. If you think about it, had you not had a promoted interest, you would have been entitled to 10% of the $200 proceeds.
B would have gotten $20. Instead, B got $50. So what we think could happen is that the first $20 is long-term capital gain, because you did hold it over a year, and the remaining $30 is reclassified as short-term capital gain, because that amounts to you promoted interest. That’s a very basic example and again it’s just one interpretation.
The IRS has a lot of regulations to issue as it relates to this provision. Until we get more guidance, we really can’t tell you with certainty how it will apply. Just know that it’s out there and it applies to any transaction, not just new entities, after 2017.
The big last section we want to cover is the section 199A passed-through deduction. This is the 20% deduction for pass-through income. The important thing to know is that this only applies to domestic entities. While I say domestic entities, what I really mean is entities operating within the United States. You may have a foreign entity, but if it’s operating within the United States it may still qualify. We’re not a 100% sure, but we believe it would.
We’re looking at partnerships, S-corporations, and sole proprietorships. To give you the history of where this came from, in the old law corporations had essentially flat 35% tax, and then you paid 23.8% on the dividends that you received from the corporations. There was an inherent double taxation that was substantially higher than the highest individual rate of 39.6% when you combined the two.
There’s a great advantage to being a partnership S-corporation or a sole proprietorship. You didn’t have that double taxation, so the most you were going to pay tax on is 39.6% depending on the type of business. You may have had another 15% of Social Security and Medicare self-employment taxes.
Well under the new law, Congress dropped the corporate tax rate to 21%. Dividends are still taxed at 23.8%, so if you do the math, you come out to about 39.8% total tax on a corporate level of income once you account for the dividend coming out. In order to make that advantage between corporations and pass-through entities still exist, they passed this deduction that reduces the top rate from 37% down to 29.6%.
That’s where you get the advantage of still maintaining your LLC’s or your sole proprietorships and S-corporations. That’s been another question, should everybody go out and become a C-corporation? Well there’s certain situations that might make sense, if you’re planning on doing a lot of capital improvements to your business, and it’s not real estate.
We would not recommend ever putting real estate into a corporate structure. You may want to consider a C-corporation. Remember that may only be a short-term gain, because while you think that you’re not planning on taking that money out today, the thought is that by making these capital improvements and spending money in the company currently, you’re going to increase its value. At some point you’re going to take out a dividend, and you’re going to have to pay tax on it.
You’re really looking at time value of money over when you’re doing it. On top of that, the corporate accumulated earnings tax, which is a 20% tax on top of the 21%, is still in play. Which means you can’t just create a C-corporation and continually accumulate the profits until it’s favorable for you to take it out. Just be mindful of that.
Let’s talk about what an income qualifies. This is the net amount of qualified items of income gain, and again we’re not 100% sure of what that means, in the context of the deduction. We’ll talk about what property qualifies in little while, and that may not exactly line up with including gain in this calculation. It includes deductions and losses regarding a qualified trader business.
It does not include reap dividends, or publicly traded partnership income. Those items get separately calculated for their impact on the 20% deduction. A qualifying trader business is any trade or business. However, it does not include investment and investment management, trading or dealing securities, partnership interests, or commodities.
When we say partnership interest, that does not include buying and selling partnership interests. It also excludes service industries in the fields of health, law, accounting, actuarial science and insurance, performing arts, consulting, athletics, financial services, and brokerage. Then the catch-all, which is that trade or businesses with a principal asset of the trader business is the reputation or skill of one or more of its employees.
That has a large definition that needs to be defined, because the question is your management company. It usually doesn’t have a lot of capital involved in it, and it’s really built on your employee’s hard work. Our thought is that businesses do qualify for this deduction. That it’s not falling into the service businesses that would be limited. That’s just our interpretation, and that could change with the IRS regulations.
Another interesting fact is that engineering and architecture do qualify. Why they got an exclusion, nobody’s really sure, other than they probably have a pretty powerful lobby. Also this deduction is code section 199A. The reason why it’s a 199A and not a 199 is because section 199 is what was called the domestic production activities deduction, which allowed you a 3% deduction on activities related to the production of income in the U.S.
It did not apply to real estate, but it did apply to construction and manufacturing. In that provision, engineering and architects were also exempt. They were able to take advantage of that, even though they generally didn’t build or construct anything. They were still allowed to take that deduction, so the thought is that it was just kept in there as a holdover from the old 199 domestic production deduction that was eliminated in the new tax reform.
There’s some limitations that we’ll talk about, and one of the limitations is that you’re limited to a percentage of W-2 income from the business. Well as an exception to the exception, you’re not subject to those W-2 limitations if your taxable income is lower than $350,000 for joint filers, or $157,200 for single filers. Then between $350,000 and $415,000 there’s a phase-out of the deduction.
Not only are you not subject to the W-2 limitation, you’re not even subject to the exclusion businesses. That’s important because for instance, if your management company is considered an excluded business for these purposes, if your taxable income is sufficiently low enough to be below these thresholds, it doesn’t matter that that’s an excluded business. You still get to take 20% of the income as a deduction.
It may be that you’re assuming your major company is excluded. It may be excluded one year and then included the next year, depending on your level of income. This is on a partner by partner basis. We think that this will have to be calculated on the K-1, and there’ll be some sort of disclosure that will be passed through to each owner for their share of these items of income W-2 wages. We’ll talk about gross assets in a minute. Until the IRS issues those new 2018 K-1s, which won’t be until probably October at the earliest, we’re not 100% sure of how this is going to work.
Okay, so let’s talk about the deduction and where it gets limited. The starting point is always 20% of the business income, and that’s your maximum deduction. Then what you take into account is if you’re a business that has wages, you take 50% of your wages. You take the lesser of the 20% or the 50%.
What about a real estate, since we’re generally operating companies that don’t have wages? For those situations, they’ve added this other provision that says, “You can also include 2.5% of the unadjusted basis immediately after acquisition, for all qualified property.”
If you’re familiar, this was the infamous “Corker Kickback” where Bob Corker and the senate were not going to vote for the passage of the bill. At the last minute this was added, and he came out and said that he was in favor of the bill. Everybody assumed that this was his provision, since he has a significant real estate holding. He also said that he had never even read the bill, so it’s good to know that he’s passing legislation without reading it.
Now if you do take this 2.5% of gross assets into account, you have to further reduce the W-2 limitations of 25%. We’ll look at this in a minute. What property qualifies? The property that qualifies is tangible property subject to depreciation that is held by and available for use in a trade or business at the close of the taxable year. That’s important when we talk about gains qualifying for this deduction.
If I sell my real estate and might sell my building, I no longer have property at the end of the year. The question is, am I going to be able to take any deduction because I no longer have property? I think we all hope that what they’ll say is that if you sell property during the year, it’s the basis immediately before the sale. I don’t think the intent was to disallow any deduction in the year sale.
The other factor that comes into play is that it includes this tangible property on hand. At the end of the year, that is also within 10 years of the date it was placed in the service. If the property is depreciable less than 10 years, the last date that it’s allowed to take a depreciation deduction for any property is over 10 years depreciable life. What that means is you’re looking at a computer that’s a five-year asset, you’re able to take that deduction over, or you’re able to include the cost of that computer into your basis for 10 years.
The other thing is that your building- commercial buildings 39 years, multifamily 27.5 years- those components are able to be included in your calculation for those periods. 27.5 to 39 years. What it also means is if you’ve got old assets that are fully depreciated through buildings, you may be extremely limited and not be able to take this deduction.
Also remember it is the gross asset value. It is not the net, so you don’t take depreciation against it each year. It’s the original cost basis. Now another thing they’ve got to take into account, is what happens if you do a like-kind exchange and now you’ve got carryover basis? You get to increase it by what you would have spent, and there’s a lot that’s got to be written.
Let’s take two examples. Let’s take you’ve got an S-corporation management company that has income of $800,000 and has $100,000 of wages. Then we’ll look at a partnership with rental income of $1 million, no wages, and property with an unadjusted basis of $10 million. So the management companies start off with $800,000 of qualified business income. You take 20%, so that’s $160,000. Well 50% of your wages is $50,000, so the most you build to deduct is $50,000.
Let’s move to limitation two, which is 20% or 25% of your wages, which would be $25,000 plus 2.5% of your property basis, in this case zero. Well that limitation is $25,000. The 50% limitation is higher, so you go back up to that and now you’re living in a $50,000 QBI deduction.
Even though under normal circumstances your eligible deduction will be $160,000, you’ve essentially reduced your deduction from 20% down to 6.25%. Not an ideal situation for a company that maybe doesn’t have a lot of wages, and is not capitalized with assets. The reason this isn’t great for real estate is because you’ve got tons of assets normally.
Now you’ve got a partnership with a million of QBI and an unadjusted basis of $10 million, so you’re going to use your limitation of 2.5% of the $10 million, $250,000. 20% of a million is $200,000, so you get the full benefit of the $200,000. I just want to make sure that you’re aware of that, and that you understand the benefit to having a real estate company, because this is really going to come into play for your real estate entities.
What’s next? Well there’s a lot that’s going to come out over the next year. We’ve talked about a lot of different things today, and there’s still a lot of questions about most of it. In the next couple of months, the Joint Committee on Taxation will issue their Blue Book, which is basically a clarification of what Congressional intent was when they made these changes.
Then Treasury has 18 months to issue regulations that are retroactive to the date of enactment. The bill was signed on December 22nd, which means Treasury has 18 months from December 22nd to issue regulations related to all these provisions.
There’s over a 110 separate areas in the law that Congress told Treasury to write regulations on. They’ve got a lot of work to do. We’re hoping they’re going to tackle the big ones first, which would mean 199A carried interest and interest expense, but we don’t know what their priorities are.
In the meantime, Treasury will issue interim notices. They’ll just give small clarifications. They’re not necessarily regulations, as far as rules of law go, but they give you an idea of what they’re going to challenge and what they’re not. The first one of these we talked about was the clarification that you can’t just go write a check for your property [inaudible 01:15:56].
At the end of the day, there’s a lot that’s going to be done. Another thing is that because this law came into place so quickly, and you went from September to December to put together this whole tax reform and get reconciliation between the house and senate, there’s a lot of places that need clarification.
The problem with the technical side is that they have to be voted on by a 60% majority of the Senate. There’s a 60 vote majority in the Senate, they can’t have a 50/50 vote. The chances of getting those passed are very slim, so we may have to live with an imperfect law until some major compromise can take effect.
The other thing about this law is that with some of these newer provisions, especially 199A, it is going to be years before all of the clarity come into play. There’s going to be a lot of assumptions made in the accounting community about how this is going to be calculated.
Now obviously we’re looking with your best interest at heart, and want to be as aggressive as we can. You may find the same entities taken to different firms could result in different qualified business income allocations. Depending upon how each firm looks, especially service businesses.
You shouldn’t get a difference of opinion in operating real estate, but you could with your service businesses. That’s where the real work has got to be done, and the real regulations have to be made. Hopefully those regulations come out sooner rather than later, because we’ve got to make decisions starting in April for estimated tax purposes.
Just keep that in mind, that this law is evolving quickly, and every day we’re learning new things. The answer that you get to a question today may not be the same answer you get a week from now. It all depends on what’s coming out, and there’s a lot to keep on top of. Keep that in mind as you bear with us for the next couple of years, as this law really takes shape and evolves into what Congress intended it to do.
With that, I’ll open up the [inaudible 01:18:35] is any questions, you’ll feel free to type them into the slide deck or into the panel.
Okay, so there’s a question about the $25 million rule regarding the cash method applying to entities with inventory. It will still apply to entities with inventory. I think they just have to use the accrual method for the inventory. I can look that up and we can get back to you on that, but thanks for that question.
I don’t see any more questions, so what we’ll do is we will wrap it up, but feel free to email us or call us. We’ll be glad to answer your questions.
I know sometimes with all the information that you’ve been taking in, it takes a while to absorb it all and come up with your questions. So feel free to reach out with us or your Aprio advisor. Thank you all for your time today and I hope you have a good weekend.
Ross Boardman: Thanks guys, take care.